What are the two major types of strategiesfollowedby hedge bond funds?

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Answer 1

Hedge funds use a wide range of trading strategies and techniques in an attempt to earn superior returns. In general, the strategies can include one or more of the following: leverage, short selling, arbitrage (i.e., simultaneous buying and selling of related financial instruments to realize a profit from the temporary misalignment of their prices), and risk control (which is more general than hedging and often involves the use of financial instruments such as derivatives to reduce the risk of loss).In regards to two specific major types of strategies followed by hedge bond funds, they can be classified as: convergencetradingand distressed investing. More details on these two strategies are given below.

To understand hedge bond funds that pursue convergence trading strategies, it is necessaryto understand that there are certain yield relationships observed in the bond market thatare viewed as stylized facts. For example, supposed that the difference in the yield spreadbetween yields offered on two types of bonds have historically fallen within a certain rangean extremely high percentage of times. If an observed relationship between the yields onthe two bonds is out of line but is expected to realign to the historical relationship, thenthere is an opportunity to capitalize on this expectation. For the strategy to succeed, theperceived misalignments of yields must move back to or "converge" to the expected relationship.Hence, these hedge bond funds are referred to as convergence trading strategies.Hedge fund managers believe the misalignment will generate a profit with little risk andtoo often refer to such a strategy as a "risk arbitrage strategy." This is a regrettable mislabelingof a convergence trading strategy because an arbitrage strategy indicates that there is no risk.The groups of bond hedge funds that fall into the category of convergence trading hedgefunds are fixed-income arbitrage hedge funds, convertible bond arbitrage hedge funds, andrelative value hedge funds.

Hedge bond funds that pursue distressed investing take positions to capitalize on theanticipatedimpact of a bankruptcy on the value of a bond. It could be investing in acorporationthat is in a Chapter 11 bankruptcy proceeding or anticipated by the hedgefund manager to be forced into filing a Chapter 11 bankruptcy. However, the strategy is notlimited to corporate bankruptcies. Hedge bond funds also are key participants in the bondmarket for the debt of bankrupt municipalities or those likely to have a bankruptcy filing.Bankruptcy is not the only condition that may provide for an opportunity to generate attractivereturns. A company that has defaulted on its obligations may provide opportunitiesas the price of the bond issue declines. Sovereigns provide a good example. The bonds ofentities that are in bankruptcy as well as those where the issuer has defaulted are said to bedistressed securities. The objective of the hedge fund manager is to identify distressed securitiesthat are undervalued relative to what the hedge fund manager believes will result fromthe outcome of the bankruptcy proceedings.To see the participation of hedge bond funds in distressed securities, look at a recentmunicipal bond bankruptcy. The city of Detroit is the largest municipal bankruptcyas of mid-June 2014 . Hedge bond funds have purchased the pension bonds and generalobligationbonds of Detroit backed by monoline insurance firms that hedge fund managersbelieve to be underpriced. The pension bonds, for example, could be purchased at a priceof 41 cents on the dollar. Just two weeks after Detroit's bankruptcy filing, the supply ofsuch bonds dried up in the marketplace.Bonds do not necessarily have to sell at very deep discount prices for hedge bondfund managers to identify an opportunity.